Last year was a painful one for investors in Smithson (LON: SSON), whose annual results to the end of December revealed an NAV total return of -28.1%, which was almost 20% behind its MSCI World Small and Mid-Cap benchmark. The popular investment trust’s growth-oriented portfolio was badly affected by the sharp increase in interest rates, but with the hiking cycle potentially nearing the peak it is possible that the worst could now be over.
Manager Simon Barnard’s quality growth approach means that he will not invest in sectors such as energy and utilities, which turned out to be the strongest performing parts of the market in 2022. To make matters worse, his favoured areas of technology and consumer discretionary were two of the biggest fallers.
Barnard admits that the underperformance wasn’t all due to macroeconomic factors and acknowledges a number of mistakes, the most important of which was not selling some of the holdings that were overvalued at the end of 2021. These included Domino’s Pizza Enterprises and Fortinet that had been trimmed, but not aggressively enough.
The biggest detractors from the performance typically saw a deterioration in fundamentals with drinks maker Fevertree being a prime example. This was impacted by strong cost inflation as it kept prices low and was responsible for 3.2% of the fund’s NAV decline, although Barnard believes it can rebuild margins and continue to grow revenues.
Sticking To His Guns
Despite the difficult year, the manager believes that companies with low levels of cyclicality and strong balance sheets should weather the storm better than others. However, they will still be impacted if the recession is worse than market participants expect.
Barnard thinks that interest rates will move back to historical averages, with inflation rates and commodity prices declining, supply chain bottlenecks easing and employment growth slowing to temper wage inflation. If he is right then the bearishness could well be overdone.
His view is that we may be close to the end of the stock market declines due to inflation and interest rates, although the recessionary fears may not yet be fully priced in. He is adamant though that he will not be discouraged from his quality growth style and will avoid the temptation of “style drift” in an attempt to make money in all conditions.
Outlook
The broker Numis says that Smithson benefits from a high-profile management group that is popular with both retail investors and wealth managers, yet despite a strong following it has moved from a premium to a discount. It currently trades around eight percent below NAV with the company consistently repurchasing shares to provide some support.
Numis think that the gyrations between growth and value may continue to dominate investor sentiment for some time. They believe that the performance in a higher rate environment may become more dependent on stock selection rather than the overiding style, although investors will probably want a better balance after becoming too exposed to growth.
Smithson shares have had a nice bounce since the end of the reporting period and are up 13% year-to-date. If interest rates are close to their peak and inflation continues to soften with the global economy avoiding a hard landing, then this sort of quality growth strategy should enjoy a good recovery, but it’s a big if.